‘Show me the incentives, and I will tell you the outcome’ is a phrase attributed to Charlie Munger, the Vice Chairman of Berkshire Hathaway and long-term business partner of Warren Buffett.
Incentives and behaviours are where psychology, economics and risk management overlap. Poor incentivisation will always represent a risk, and good incentivisation can provide a strong control that helps you achieve your objectives.
For example, contracts for supply of goods or services on a cost-plus basis are unlikely to help you control costs. The supplier is reimbursed for their costs and then it gets a mark-up on top; that means that the supplier gets all of their costs back, however high, and then, say, 15% on top. There is no incentive to contain costs, and every incentive to overstate the actual costs. The US Department of Defense realised that it had been taken for a ride for so long on these type of contracts that they made it a felony for the federal government to write any more cost-plus contracts.
The really smart thing is to use incentives positively to achieve your goal.
In 1787, the Philadelphia Convention was held with the ultimate purpose of agreeing the Constitution of the United States of America. It was held totally in secret, and there were no recorded votes until the final vote, and then there was just one recorded vote: a vote on the whole constitution. These rules ensured success, if only by a whisker. If it had not been for these rules, delegates may have been pushed into a corner by their pronouncements or their oratory, or by their voting record, all of which they might have wanted to retract as the Convention proceeded. If such votes or pronouncements had been recorded and made public, there would have been a powerful incentive for many to stick to what they had previously said so they would not be seen to have caved; they would then not have voted for the final version of the Constitution, and America may have remained a loose confederation of states, or have even split up at that very early stage in its history.
Sadly, most risk management methodologies ignore how to identify and assess incentives as risks or as controls.
Data Source: 1995 speech to Harvard Law School by Charlie Munger entitled: “The Psychology of Human Misjudgement’.